Upside of Wall St. Failures? Nothing

“The truth may instead be that the finance industry not only has fewer missteps than the rest of corporate America, but that sometimes failure is a good thing.”

-Steven M. Davidoff

Just what we needed, another silly article defending yet another Wall St. failure.

Following Knight Capital’s $400 million dollar computer trading error, there was a bizarre article in the NYT’s Dealbook earlier this week. It tried to make the case that Wall Street’s occasional snafus are really no big deal. I want to clarify a point on Knight, and then explain why this Dealbook article is so ridiculous.

First, about that Knight Capital snafu. They tried to bring a new computer trading technology online, they failed (miserably) to adequately test it and/or anticipate a variety of potential errors. It cost them nearly half a billion dollars. Their stock (KCG) plummeted 74%. The firm required a lifeline from outside investors, and numerous people were — or will be — sacked.

I have precisely zero problems with this scenario.

A company, as happens quite often, screwed up royally. They were not bailed out by taxpayers, their losses were not externalized to third parties. The people responsible for the errors were not given a free pass, the global economy was not driven to collapse. No laws were broken. No new regulations were required to respond to this. There will not be Congressional hearings on this issue. All told, exactly what was supposed to happen happened.

I wish more of our financial cock-ups looked like this one.

And therein lies the absurdity of the NYT article. What should be a typical case of a major brokerage/banking error is notable because it is the exception — not the rule. This is how companies are supposed to fail. They do something wrong, they pay the price, and they either go out of business, or bought on the cheap or broken up for parts.

But what the author failed to recognize is what makes the finance sector different from all other sectors: The impact it has on the rest of the economy. When Research in Motion or Sears messes up, well its bad for RIMM and SHLD. Even Microsoft’s lost decade has only hurt Mister Softee and their shareholders and users — not the entire global technology infrastructure.

When AIG or Citigroup or Lehman Brothers or Bank of America or Bear Stearns or Long-Term Capital Management mess up, it is not an exaggeration to say it threatens the global economy. Look at the damage MF Global caused versus the collapse of WorldCom. Or Refco versus Tyco. The list goes on and on.

There are numerous reasons for this distinction, but consider these three:

1. Credit Issuance: Credit has become the lifeblood of the global economy. When these firms slow or stop issuing credit due to their errors, it has a major impact on economic activity. Yes, companies are too dependent on short term credit, but that is the environment bankers helped create — they must be cognizant of the impact they have.

2. Leverage: Beyond credit, no other industry uses so much leverage to achieve profitability. Other sectors throttle back during slow downs, but Bankers ramp up from 8X to 40X to maintain profitability because they can. When they slip up, they crash and burn, rather than merely stumble.

3. Fiduciary: Many financial institutions have (or appear to have) a fiduciary obligation to clients. When they betray that trust, it appears to be far worse a violation than merely missing a quarter.

This was the genius of Glass Steagall. When bankers had their all-too-regular implosions, they did not spill over onto Main Street. Just look at the impact of the 1987 market crash on the real economy — it was de minimus.

We shouldn’t have to jump up and down and cheer “Yeah! A Wall Street company screwed up, and the rest of the world did not implode.” That should be our default setting. That its not tells you all you need to know about what is wrong with our financial system.